The stock price of a company usually depends partly on its book value. If the company has acquired other businesses, then some of its book value will depend on the value of those other businesses. However, a large part of the book value of acquisitions may be assigned to goodwill, a catchall phrase that refers to the value of the business over and above the value of its assets. Some factors giving rise to goodwill that would not be evident in the company's balance sheet include the reputation of the business, a large customer base, established distribution system, and the quality of its employees.

However, goodwill can easily be inflated by management, giving the company a greater value than it actually has, especially if it overpaid for it. Goodwill — sometimes known as accounting goodwill to distinguish it from economic goodwill, which is the excess of the market price over the net worth of the company — is an intangible asset, the value of which is recorded on the acquiring company's balance sheet as the difference between what it paid for the acquisition and the acquired company's fair market value, or book value.

Goodwill of a Company = Purchase Price — Book Value of Company

Because goodwill is not a specific asset that can be easily measured, a company cannot include goodwill in its own balance sheet in calculating its net worth. Moreover, goodwill is no longer amortized, but, to comply with FASB Rule 142, Accounting for Goodwill and Intangible Assets, it must pass an annual impairment test (guidelines are provided in FASB ASC 350, Intangibles — Goodwill and Other and FASB ASC 360, Property, Plant and Equipment), to determine if the goodwill is still worth what was paid for it. An impairment test may also be required if a triggering event occurs that would cause a decline in the value of the business.

Because goodwill is the amount paid over the value of the business assets, goodwill can be described as the extra earning power of the business compared to another business with similar assets. It may also indicate the potential earning power in the future as projected by the management of the acquirer or the potential increased profit because of the synergy between the businesses of the acquired and the acquirer. However, projections may be wrong, and oftentimes, an acquired company may suffer from the bureaucratic management or lack of vision of the acquirer; e.g., witness the decline of MySpace when it was acquired by News Corporation. If, with the passage of time, it becomes evident that the business was not worth its assigned value, then the value of the goodwill must decline with it. Hence, goodwill impairment tests focus on triggering events that may reduce the value of the business, such as the following:

Indeed, during the 2007-2009 Great Recession, high amounts of goodwill value were written down by many companies, peaking in 2008.

If goodwill is found to be impaired, if its fair market value is less than its carried value, then it must be written down. According to generally accepted accounting principles (GAAP), the value of the goodwill cannot be increased even when business conditions improve. This will diminish stockholder equity, and may trigger covenants on any debts that the acquiring company has issued, and thus, imposes a risk for current stockholders. Such is the current case with Expedia, as is illustrated by this article: Tracking the Numbers -

An impairment loss is a non-cash item that reduces current earnings and total assets. Less assets may increase return on assets in the next accounting period. Analyzing accounting entries for goodwill and impairments is effective for analyzing the quality of management: how well they choose and assimilate acquisitions.

The Purpose of Listing Goodwill as an Asset

Why do accounting standards even allow goodwill as an asset? Consider Facebook's 2014 acquisition of WhatsApp, for which it paid $19 billion in stock and cash, and recorded $18.1 billion of that purchase as goodwill, since WhatsApp had very few assets and little revenue. Facebook paid $19 billion because it thought that the company would be worth that much in the future, especially if it were combined with its own business. Facebook stated that it hopes to monetize it in the next 5 to 10 years. If it could not record the $18.1 billion of the purchase as goodwill, then Facebook's book value per share would immediately decline by a significant amount, since it would otherwise be like giving away $18.1 billion of cash and stock, causing a substantial decline in its stock price. That scenario was prevented because Facebook was allowed to record $18.1 billion as goodwill.

Was WhatsApp worth $19 billion? No one knows at the time of the acquisition, but it will become more readily apparent in time. This is why the allocation to goodwill must pass the impairment test at least annually, if not more frequently if justified by better information. Consider 2 extremes:

  1. WhatsApp was worth its $19 billion purchase price, in which case, Facebook will profit from its acquisition.
  2. WhatsApp turns out to be worth nothing, as technology and marketing strategies advance to reduce the value of its service. In this case, Facebook did give away the $18.1 billion, and its own value will decline accordingly, along with its stock price.

Now, WhatsApp is probably worth something, but there is a good chance it was not worth the $19 billion paid for it, in which case, Facebook will eventually have to write down some of its value. This is a risk for any company — and for any investor in that company — that records a significant amount of value as goodwill. For tax purposes, any loss of goodwill is not recorded as a loss, since it is not tax-deductible, but it is also a non-cash item, since Facebook already paid for the acquisition.